Explanation: The Fed signals that it is ready to reduce its balance sheet. Why this is such a big deal

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The Federal Reserve Building is pictured in Washington, DC, the United States on August 22, 2018. REUTERS / Chris Wattie

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Jan. 6 (Reuters) – The Federal Reserve is poised to reduce its holdings of more than $ 8 trillion of bonds, with a reading from the US central bank meeting last month suggesting the process could start later this month. year.

This signals a significant difference from the way the Fed handled its policy of “normalization” after the 2007-2009 financial crisis, and a much faster removal of extraordinary accommodations overall than last time around. It also shows that officials have greater confidence in the strength of the current economic recovery after the coronavirus pandemic than they had after the recession more than a decade ago.

Fed Chairman Jerome Powell told reporters after the Dec. 14-15 policy meeting that policymakers may be able to act faster than in the past when it comes to reducing the balance sheet, observing that officials see “a very different economic situation than we have.” at present. “

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The minutes of that meeting released on Wednesday showed officials were engaged in a lengthy discussion about shrinking the central bank’s balance sheet, a move that could have a significant impact. Financial markets are reacting, with bond yields rising on Treasury maturities sensitive to signals from the Fed on both interest rates and its balance sheet.

1) WHY ARE THE FED’S ASSETS IMPORTANT?

The Fed began using large-scale asset purchases – also known as quantitative easing, or QE – during the 2007-2009 financial crisis when it became clear that simply lowering short-term interest rates , its traditional political lever, would not suffice on its own.

Buying tens of billions of dollars in both treasury bills and mortgage-backed securities has helped lower long-term borrowing costs for businesses and households, and helped mend a market broken credit and foster an economic recovery, even if it took years.

After three waves of buying programs between 2008 and 2014, the Fed had amassed about $ 4.25 trillion in bonds, and the yield on the 10-year U.S. Treasury bill is influencing rates on everything from auto loans mortgage loans, had fallen from over 4% to well below 2%.

When the coronavirus pandemic unfolded in early 2020, it caused a global panic in financial markets, and the Fed again responded with massive bond purchases as well as interest rate cuts. Its bond holdings now total approximately $ 8.3 trillion, of which approximately $ 5.65 billion is in treasury bills and $ 2.65 billion in MBS. It holds about a quarter of the treasury market.

2) WHY DO OFFICIALS WANT TO ACT MORE AGGRESSIVELY THIS TIME?

Fed officials say the US economy is much stronger today than it was in previous periods when the central bank removed its accommodation measures. Officials want to make sure they have leeway to respond to high inflation well above their 2% target. They are also encouraged by improvements in the job market and are confident that they are approaching their maximum employment goal, according to the minutes of the December meeting. This would mean that there is not as much need for Fed support.

Several policymakers are also worried that the Fed’s large balance sheet and its policy of keeping interest rates ultra-low may contribute to rising asset prices. Home values ​​have jumped during the pandemic as some families sought to take advantage of low mortgage rates to move away from dense city centers. With stock markets recently hitting record highs, officials don’t want to be seen as fueling unwanted asset bubbles either.

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3) WHAT HAPPENED WHEN THE FED LAST REDUCED ITS BALANCE SHEET?

When the Fed stopped increasing its bond holdings at the end of 2014, it was initially reluctant to reduce the size of its balance sheet for years, even after it started raising interest rates in late 2015. Officials saw the recovery as much softer than the current rebound after the short but deep recession of early 2020.

The central bank finally began the shrinkage in 2018, allowing a number of bonds to mature each month without the principal repaid being reinvested in new securities, a process that has come to be known as tightening. quantitative, or QT. About $ 650 billion in bonds had been pulled from the Fed’s portfolio in September 2019, when it was forced to abruptly shut down QT after a key short-term credit market went haywire and it became evident that too much money had been drained from the system.

The minutes of last month’s meeting showed that “many” Fed officials felt that the appropriate pace of its balance sheet reduction would be faster this time around.

4) THE LAST QT ENDED WITH A UTILIZATION IN A KEY MARKET. CAN THIS COME BACK?

In 2019, the level of reserves held by banks with the Fed fell too low. This liquidity shortage caused short-term lending rates to skyrocket and forced the central bank to intervene in money markets to keep them functioning.

Many financial companies are now facing the opposite problem: too much cash. The Fed also has a new tool called the “permanent pension facility” – or SRF – which can provide a safety net for cash-strapped companies, although it never worked in a QT environment.

Minutes from last month’s policy meeting show Fed officials remain uncertain how far they can go to deplete reserves, and they say they will monitor money markets closely for signs of a cash crunch as they cut bond holdings.

Still, several officials said the SRF could reduce demand for reserves, according to the minutes, potentially allowing for a smaller balance sheet than would be manageable in the absence of such a tool.

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Reporting by Jonnelle Marte and Dan Burns Editing by Paul Simao

Our Standards: Thomson Reuters Trust Principles.


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